Bonuses done right are an essential tool

Allister Heath was Editor of City A.M. for six years up until June 2014.

Allister Heath

SO bonuses are back. This is great news for many readers of this newspaper, the majority of whom work in financial services; but many others will find this return of the mega-payout to be entirely offensive. After all, the &ldquo;bonus culture&rdquo; &ndash; when huge financial rewards are meted out, regardless of real, long-term performance &ndash; had a corrosive effect on numerous financial institutions during the bubble days.<br /><br />Shareholders were routinely looted for the benefit of a small cadre of employees; and when the music stopped and asset values collapsed, the former were left with worthless banks or investment vehicles and the latter retired to Spain or Florida to spend the rest of their days in luxurious idleness. Taxpayers, meanwhile, picked up the tab. Most people now accept that many firms got their compensation schemes wrong &ndash; even if the additional risk-taking this triggered was only a marginal contributor to the overall crisis, contrary to what is often claimed. So the last thing we need is to return to business as usual.<br /><br />But any anger should be tempered. The return of the mega-bonus shows that many institutions, led by Goldman Sachs, Morgan Stanley, JP Morgan, Barclays Capital and Deutsche Bank, are making huge profits again; and this confirms that the worst of our economic woes are behind us and that the financial system has returned to stability. Every indicator suggests that economic output &ndash; in manufacturing, construction as well as services &ndash; is now either shrinking much less quickly or has returned to growth. There are dark clouds on the horizon, with the possibility of a double-dip into contraction next year as governments slam on the monetary and fiscal brakes, but there is no denying the significant shift in our economic fortunes. <br />And there is nothing wrong about bonuses per se; it makes sense to compensate people through a mix of a base salary and a performance-related component. Incentivising staff is a good thing; and there is nothing better than pecuniary incentives. A blanket ban on banking bonuses would merely lead to an exodus of talent to smaller boutiques and hedge funds; a total ban on UK bonuses would kill London and send our best and brightest to other, more enlightened jurisdictions. But bonuses must be structured correctly: they shouldn&rsquo;t be paid out today for investments that turn out disastrously in a year&rsquo;s time; clawback mechanisms need to be available. Rewards need to be as long-term as possible; the bonus/malus scheme pioneered by UBS is the way to go. It makes sense to pay bonuses in equities, though this no panacea: Lehman Brothers did just that and we all know how it turned out.<br /><br />There are problems, however. Some firms have been discussing two-year guarantees with some potential traders and sales executives. This is not a good move: bonuses need to be performance-related, not automatic or else they lose all purpose. Morgan Stanley allocated $2.08bn for possible compensation during the first quarter, an excessively elevated 68 per cent of total revenues. While the firm certainly needs to pay its staff competitively, these sorts of payout shares are way too high for comfort.<br /><br />So it would be wrong to engage in a knee-jerk condemnation of City bonuses; but it would be equally stupid for City firms to hark back to the bad old days.<br />allister.heath@cityam.com